Tech companies are all about innovation – how obvious is that? And how well you run your R&D innovation and processes is a major determining factor in a company’s success, no more so than in the fast moving world of SaaS technology. No matter how good your Sales and Marketing functions are, they need to continually be producing competitive products to succeed.
This time of year, most SaaS companies are reviewing their plans and budgets for 2016. For R&D, that means looking at how much to put in the 2016 budget for overall R&D spending, how many new engineers, developers, systems operators, designers, testers, technical directors, etc., to hire, what kind of workloads can be managed, and so on.
Budgeting Bottoms Up/Top Down
In the budget and planning process, companies typically follow a bottoms up/top down process. Bottoms up, companies look at product development requirements coming from customers, prospects and the overall market, while from the top down, try to fit those requirements into revenue growth and profitability goals.
Most companies have a hard time analyzing the return on R&D investments, other than some very general rules of thumb around what they want total R&D spend to look like as a percentage of recognized revenue. This rule of thumb, however, is misleading as there are plenty of successful companies spending a high percentage on R&D and other successful companies spending a much lower percentage. The percentage by itself doesn’t tell you much about whether R&D will drive growth and there is very little correlation with market valuations.
Return on R&D Capital (RORC)
Another way to look at R&D spend is to look at what the R&D spend got the company in terms of gross profit. We call this metric Return on R&D Capital (RORC) which divides this year’s gross profit by last year’s R&D spend, assuming roughly a one year return on R&D investment. This is somewhat similar to the Magic Number which looks at the change in subscription revenues and divides it by a previous period’s sales and marketing spend to get an indicator of whether a company has a profitable subscription model. R&D investment is assumed to take about a year to take effect in the market and see the return.
Gross profit is a good measurement of the impact of R&D investment as it is the sum of revenue, minus the cost of revenue. For SaaS companies, cost of revenue includes hosting and monitoring expenses, as well as licenses and royalties embedded in the application, ie., not a result of the company’s innovation spend.
RORC = This Year’s Gross Profit / Previous Year’s R&D
Let’s look at some examples and what kind of benchmarks we can identify for SaaS companies. First off, apply the RORC formula to Apple – the ultimate leader in driving profits from their technology spend. Apple’s return on their dollar was $19 of gross profit in 2013 and just under $16 gross profit in 2014.We are doing this analysis using FY2014 financials as FY2015 isn't available for most companies, and looking at 2014 can help companies set up their analysis for 2015 and 2016.By contrast to Apple's performance, IBM’s 2014 RORC was about $8 gross profit for every dollar of R&D. Oracle’s return in gross profit for every dollar spent was $6.40 and EMC’s was $5.52.
SAAS RORC
SalesForce.com for FY 2015 (ending Jan.31, 2105) had a RORC of $6.5 gross profit for every dollar – much less than Apple but not much less than IBM and just above Oracle. SalesForce is spending almost 15% of revenues on R&D, similar to Oracle at 13.5%, but almost 3 times what IBM is spending, which benefits from many mature business segments requiring less innovation and producing more profit.
In general, RORC goes down as companies get smaller. Average RORC for public SaaS vendors under $150M was $3.36, which is still a decent return, considering that so many smaller public SaaS companies are not profitable and R&D spending is in the 30% to even 80% of revenue range. RORC ranges from a low of $1.17 to a high of $8.09 for these 20 companies with revenues under $150M.
R&D Return Compared to Market Cap Multiples
Now take a look at the return on R&D dollars compared to market cap multiples. The SaaS vendors with the highest market cap multiples on revenue did not have the highest returns on their dollars, but have some of the highest percentages of a percent of revenue.
We find SaaS vendors in the pre-IPO and early public revenue ranges tend to have quite low RORCs and relatively high spend, which speaks more about where these companies are in their innovation life cycle than their current profitability. They will need to closely monitor this as they grow in order to show investors the results of their investment.
There's No Silver Bullet
SaaS businesses are complex to model and need to take into account a whole range of moving parts. No one metric will guarantee success. And all performance metrics are dynamic, ie., a change in any one of them will impact all the other results, in addition to changing at various growth stages. In order to target the "right" performance number for your company, it is important to continually benchmark your company against peers to see what can be achieved, and what is expected by stakeholders.
Key Takeaway
R&D spend as a percent of revenue says more about where a company is in its innovation cycle, but not about the overall business model success. We recommend that the return on R&D capital (RORC) gives a good indication of the profitability of a SaaS company’s innovation investments in the context of what it returns. We recommend this metric as a way to track these investments and to benchmark your company against peers in order to continually monitor the management of your spend, as well as whether it is translating into results.
